Which Debt Do I Pay Off First?

"I have a loan for $5000 with a 10.25% interest rate. a $3500 loan at 15.49% interest. and a credit card with $2700 outstanding at 17.9%. Which do I pay first?"

First of all, thank you for making your question easy on me since the answer in your situation is fairly straightforward.  You will see why shortly.  In most cases, it isn’t that straightforward.  If you read my posts regularly, you may be familiar with my philosophy that personal finance and financial planning are just as much about dealing with emotions as it is about dealing with the numbers.  This is very relevant with your question.

We’ll start with the numbers.  The simple answer here is to pay off the debt with the highest interest rate first, and work your way down to the one with the lowest interest rate.  One thing to consider in this approach is whether or not the interest that you are paying is tax deductible.  If it is, then realistically your interest rate is lower.  As a quick example, let’s say you have a student loan at 6%, and you are in the 25% tax bracket.  You determine that you can deduct your student loan interest so realistically your interest rate is 25% lower or (6% x (1-25%)) = 4.5%.  Your home mortgage interest rate may be affected in a similar fashion though this can be a little more complicated.  Other loans that rates can be affected by taxes may include business loans and mortgages on rental properties.  As financial planners, these are what we take into consideration when calculating financially which loan makes the most sense to pay off first, second, third and so forth.  In some cases, it might not make financial sense to pay off the debt early.

Equally important is the emotional side of paying down the debt.  It is never an easy process paying down debt and there needs to be a serious commitment in doing so.  If your highest interest rate loan is also your largest balance, it may be a daunting task to pay it off first.  If you are noticing very little progress, emotionally you may feel like giving up.  Conversely, you should be getting excited to pay off debt.  You want to see progress because progress will reinforce why you are doing this in the first place.  For this emotional reason, it makes sense to pay down your lowest balance debt first, and then pay off the next smallest balance, and so on and so forth.  Dave Ramsey refers to this approach as the debt snowball.  I believe Dave’s books and courses do a tremendous job of outlining a way to get out of debt.  I do not agree with Dave on all of his teachings but definitely recommend his stuff for eliminating debt.

I hope you don’t mind me going through all of this before answering your question.  By now it should be pretty evident what you should do.  Since your highest interest rates are also on you lowest balance your situation is straightforward.  I took the liberty of offering more explanation so that others could learn from your question as well.